Visa Shares Have Big Legal Risk (Update1)

Visa story updated to include details on exposures of Bank of America, JPMorgan and Citigroup in paragraphs 22-25 and response from Citigroup and JPMorgan spokespeople in final paragraph.

NEW YORK ( TheStreet) -- Visa ( V) shares have been on a tear this year, and trade at more than 24 times trailing earnings, versus about 13 for the S&P 500, but recent regulatory filings offer a reminder of the massive legal risks the company faces.

On Dec. 23, Visa disclosed it had added $1.565 billion to an existing litigation escrow account it has had since at least 2008, the year of its initial public offering. The account now stands at roughly $4.3 billion, according to a report by Jefferies analyst Jason Kupferberg.

The shares roar ahead despite three times "tens of billions" in legal exposure

That is more than 10 times the $425 million Visa had in a litigation reserve as of Sept. 30, according to its latest 10-K.

The discrepancy is unusual, according to Ed Ketz, an accounting professor at Penn State University.

Ketz explains that money in an escrow account represents "actual assets being set aside." By contrast, the Financial Accounting Standards Board is "a little lax" in determining what needs to go into a litigation reserve.

"If it's not probable -- or you can't estimate it reliably -- then you don't have to record the item, so that means that the numbers you typically see on litigation reserves are understating what the true amounts are," Ketz says.

Ketz interprets the sizeable sum allocated to the escrow account as evidence that Visa is "anticipating some sort of future losses with respect to litigation. "Otherwise," he says, "I don't understand why they're doing what they're doing."

Visa would not comment beyond its Dec. 23 filing, but according to a report by JPMorgan analyst Tien-tsin Huang, the losses likely relate to a more than seven-year legal battle pitting the credit card company and MasterCard Inc. ( MA), along with several banks, including Bank of America ( BAC), Citigroup ( C) and JPMorgan Chase ( JPM) against a group of merchants who accuse the companies of price-fixing related to fees on credit and debit card transactions.

Huang expects a settlement prior to the trial date of Sept. 12, 2012, and while he notes that last week's deposit into the escrow account is the largest so far, he calls it "not that surprising," and retains his "overweight," rating on Visa shares.

In fact, the seemingly negative news may actually have had a positive affect on the shares, since, as part of a complex agreement governing Visa "class B" shares, any increase in the litigation escrow account is effectively treated as a buyback. That led Goldman Sachs analysts to raise their estimates and price target on Visa Tuesday.

While accounting professor Ketz says that he has "never seen anything like this before," he sees nothing innately troubling about a shareholder agreement that causes an increase in a litigation escrow account to result in a decrease of total shares outstanding.

He notes, however, that because the deposit into the escrow account reduces both the numerator earnings and the denominator share count "it's not 100% clear what the effect on earnings per share is going to be."

That will largely depend on how much the litigation ultimately costs, and Visa's description of the merchant litigation in its regulatory filings is far from reassuring.

"Plaintiffs estimate that damages will range in the tens of billions of dollars. Because these lawsuits were brought under the U.S. federal antitrust laws, any actual damages will be trebled," the 10-K states.

Got that? That's three times tens of billions!

To explain how it is protecting shareholders against this exposure, Visa takes them deep into the swamp of corporate speak, offering the assurances that "the allocation of any monetary judgment or a settlement among the defendants is governed by an omnibus agreement dated February 7, 2011," and adding that "the Visa portion of a settlement or judgment covered by the omnibus agreement would be allocated in accordance with specified provisions of our retrospective responsibility plan."

So Visa shareholders worried about three times tens of billions of exposure must wade through an omnibus agreement and a retrospective responsibility plan.

Despite the daunting-sounding name, the omnibus agreement appears mostly to divide the responsibility for alleged anticompetitive practices between Visa and Mastercard, with Visa paying out two-thirds of any judgment or settlement versus one third for MasterCard.

Still, two-thirds of three times tens of billions is an awful lot of money, even for a company as large as Visa, which is where the retrospective responsibility plan comes in.

Indeed, the retrospective responsibility plan appears to be the most critical bulwark Visa has built against its massive legal risks.

How critical? Visa tells us that "failure of our retrospective responsibility plan to insulate us adequately from the impact of such settlements or judgments could result in a material adverse effect on our financial condition and cash flows and could even cause us to become insolvent."

Insolvent? So what is this plan? Visa tells us it "consists of several related mechanisms to fund settlements or judgments," including the escrow account, potential share offerings, and various agreements with cardholders.

One such "mechanism" looks to be loss sharing by the banks. For example, Bank of America states in its 2010 10-K that it would have to pay 11.6% "of the monetary portion of any comprehensive Interchange settlement." An adverse judgement would require the bank to pay "12.8 percent of any damages associated with Visa-related claims (Visa-related damages), 9.1 percent of any damages associated with MasterCard-related claims, and 11.6 percent of any damages associated with internetwork claims (internetwork damages) or not associated specifically with Visa or MasterCard-related claims (unassigned damages)."

Citigroup also makes mention of the issue in its 10-K, noting that "as of December 31, 2010, Citigroup carried a reserve of $254 million related to certain of Visa USA's and MasterCard's litigation matters."

JPMorgan's 10-K gives no specific numbers regarding its exposure, but takes note of the case, including the fact that "plaintiffs filed supplemental complaints challenging the initial public offerings ("IPOs") of MasterCard and Visa," on antitrust grounds. Because Visa and MasterCard were spun out of the banks, a successful challenge of the IPO could open up a hornet's nest of litigation among the defendants.

One begins to understand why, by Visa's own admission, the "mechanisms" are "unique, complicated, and tiered," but if the company "cannot use one or more of them," it "could have a material adverse effect on our financial condition and cash flows, or, in certain circumstances, even cause us to become insolvent," Visa says.

There's that insolvent word again. There's nothing new about it. It's been in Visa 10-Ks going back to 2007, the year before its IPO, along with the parts about unique complex mechanisms and the three times tens of billions.

But given that another one of those mechanisms--the escrow account--just received its largest deposit ever, it might be a good time to wonder if Visa truly has a handle on these risks.

While JPMorgan analyst Huang expects a settlement, Visa once again is hardly reassuring on this point. Its 10-K notes "substantial hurdles," to a deal, as the plaintiffs' settlement demands "have included unacceptable changes to Visa's business practices and unacceptable financial terms."

How much might Visa lose? "Under generally accepted accounting principles, the Company believes some loss is reasonably possible, but not probable and reasonably estimable," according to the heavily-lawyered language of the filing, which notes "many material uncertainties," and "mixed progress in settlement negotiations."

The filing also notes that "the current uncommitted balance of the covered litigation escrow account--$2.7 billion--is consistent with the Company's estimate of its share of a lower end of a negotiated settlement for the entire matter."

But remember, just over a month later, that number has grown to roughly $4.3 billion. We're a long way from three times tens of billions, but the company is giving us no assurances of any kind.

Nor, for that matter is MasterCard CEO Ajaypal Banga, who said on a Nov. 2 earnings call the company faces "a reasonably possible loss of at least $500 million if there is a negotiated settlement with all plaintiffs" in the litigation. But while Banga cited substantial progress with the individual merchant plaintiffs, he said "there has not been similar progress with the class plaintiffs" and as a result "it is not possible to put an upper limit on this loss."

Still, one wonders how much thinking the investors who have driven Visa shares up 44.8% year to date through Tuesday and MasterCard's up 66.5% have done about the issue. Maybe not enough.

A Visa spokeswoman declined to elaborate on last week's litigation escrow announcement from last week. She declined to elaborate on the likelihood or potential size of a settlement beyond what Visa states in its 10-K.

Spokespeople for JPMorgan and Citigroup declined to comment. Spokespeople for MasterCard and Bank of America did not response to requests for comment.